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Three Muni Bond ETFs to Weather the Coming Storm

Thanks to the recent bankruptcy of Stockton, California—the 13th most populous city in the Golden State—many investors are worried that a wave of municipal bond bankruptcies could be around the corner. After all, many cities around the country are facing steep budget deficits and with a sluggish economy, there seems to be no relief in sight for a number of municipalities around the nation.

This is particularly a problem for local administrations as opposed to the federal government. The feds can always print money or tweak the inflation rate in order to make the debt load a tad more manageable, while cities and states do not have that option (read Is The Bear Market For Bond ETFs Finally Here?).

Thanks to this, ongoing austerity problems, and worries over government finances around the world, big municipalities have been dragged into bankruptcy at an increased rate lately. In fact, according to Time, 10 of the 42 ‘significant’ municipal defaults since 1981 have come in the last four years.

With this backdrop, predictions of a muni bond apocalypse don’t seem as farfetched as they might have just a few years ago. This is especially true given how impacted broad European bond markets have been by just a few troubled nations. Clearly, it doesn’t take much to shift the tide in the bond world and it isn’t unreasonable to assume that if a few major cities approach trouble we could see a world of hurt in the U.S. municipal bond market as well.

The recent bankruptcy also highlights the importance of diversifying exposure across a variety of issuers. After all, with a portfolio of dozens or hundreds of different bonds, one or two bankruptcies are not going to destroy the portfolio (see Three ETFs with Incredible Diversification).

Thanks to this, an ETF approach may be the way to go for investors who still want to maintain exposure to the muni market or for those who like the tax benefit and bond diversification that often comes from this space. However, there are a number of ETFs in this slice of the market that are either focused entirely on Californian bonds or have a great deal of interest rate risk thanks to long-dated securities.

As a result, we think that investors should generally avoid those types of funds and instead focus in on shorter-term or safer bond ETFs in the space. Below, we have highlighted three of these funds which we believe could offer a better option for investors in the increasingly in-focus muni bond ETF market:

One safe segment of the bond market is arguably in the Pre-Refunded space. These bonds are created when local governments issue new debt to refinance old debt that was issued when rates were higher.

According to Morgan Stanley, once this refi is complete, the issuer will use the new principal to purchase safe securities—like Treasury bonds—and put them in an escrow account. The income from this account is then used to pay off the bonds until the original debt can be called, potentially making for a safer way to target the market (read The Forgotten Municipal Bond ETFs).

Currently, PRB charges investors 24 basis points a year for access to a portfolio of these securities, while the taxable equivalent yield comes in at just 0.66% for the 35% tax bracket, largely due to the safety associated with these securities.

The portfolio currently consists of 64 issues in total while the average modified duration is just 3.5 years. In terms of the fund’s geographic focus, rich states take the top spots including New Jersey, Illinois, California, and Massachusetts, each of which account for a double digit allocation in the fund. In terms of performance, the product is flat having lost three basis points so far in 2012.

For another potentially lower risk option, investors can also look to PowerShares’ PZA. The product focuses in on the ‘insured’ market of municipal bonds which means that the issues have insurance policies that are underwritten by a private firm.

Thanks to this, in the event of a default, investors can still get paid, both in terms of principal and interest payments should the worst happen in a particular municipality. With this policy investors can be reasonably assured that they will be paid back although it should be pointed out that the lower risk does result in lower interest rate payments most of the time.

However, investors should note that the product is heavily tilted towards long term securities as those that mature in at least 25 years account for roughly 47% of assets. With this high duration, the yield is somewhat impressive, coming in at 3.4% for 30 Day SEC terms (also read Forget About Low Rates with These Three Bond ETFs).

Holding exposure is tilted towards high quality bonds as AA and AAA rated securities account for 93% of assets. State exposure is focused on the usual suspects as California, Florida, and Pennsylvania round out the top three, although Puerto Rico does receive the fourth biggest allocation. In terms of performance, the product has done reasonably well, adding 3.1% so far in 2012.

For investors looking for an active approach that also focuses on short-term debt, SMMU could be an interesting choice in the muni space. Overall, the fund looks to hold a diversified portfolio of high credit quality securities which carry interest that is exempt from federal taxes.

Currently the product holds about 88 securities and it has a relatively low effective duration of just under 1.9 years. However, the yield is somewhat low—thanks to the low effective duration—coming in at just 0.9% (read Invest Like The One Percent with These Three ETFs).

In terms of holdings, New York bonds take the top spot, followed by a double digit weighting to California, and then an 8% allocation to Illinois. The rest of the top states include some in the West and the Northeast, including Arizona, Connecticut, and Washington. So far this year, the fund has been pretty much flat, adding about half a percent since the start of 2012.